Why inflation in the U.S. is a problem for the Bank of Canada

Recent economic data in the U.S. are setting up the Federal Reserve to likely keep interest rates in the United States higher for longer, posing a dilemma for the Bank of Canada, a report from BMO Capital Markets says.

Financial markets are pricing in at least three more quarter-point hikes from the U.S. central bank, which would take its terminal rate range to 5.25 per cent to 5.50 per cent. Expectations for Fed hikes rose after the U.S. central bank's preferred inflation measure came in stronger than expected on Friday, the latest in a string of data showing that economy is still running hot.

"The re-re-pricing on the Fed outlook has given the U.S. dollar yet another charge. After retreating steadily from the 20-year high hit last fall, the greenback has snapped back up since early February lows to reach its highest levels of 2023," Doug Porter, chief economist at BMO, wrote in a client note on Friday.

"And the Canadian dollar has certainly not escaped the broader downdraft."

Adding to the downward pressure on the loonie is the Bank of Canada's declaration that its hiking campaign is currently on pause to gauge how the economy is handling higher rates.

"The sudden reassessment of the potential for even more Fed rate hikes follows soon after the Bank of Canada rather publicly planted its flag in the on-pause field," Porter said.

Up until earlier this month, markets had bet the Bank of Canada would start cutting rates starting this fall as inflation continued to ease. The consumer price index dipped just below the six per cent mark for the first time in January.

However, remarkable resilience in the jobs market, among other strong economic data, and the languishing Canadian dollar have lifted the odds of a 25 basis point hike in July.

Porter says there are two main reasons the Bank of Canada could consider deviating from the Fed in terms of rate hikes: Wage and price pressures are less intense in Canada, and Canadians are much more indebted than U.S. households, making the country more sensitive to rates.

It's the loonie that will "act as a limiter on the extent of that deviation," he adds.

A lower Canadian dollar makes goods coming from the U.S., Canada's biggest trading partner, more expensive.

"The Bank may not have the luxury of staying on the sidelines if the Fed is still busily marching rates down the field, driving the loonie lower (and thereby sending imported costs flaring higher)," Porter said.

Michelle Zadikian is a senior reporter at Yahoo Finance Canada. Follow her on Twitter @m_zadikian.

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